national debt

This is the third and final blog in a series I have done on the topics of the federal debt/deficit and why money in modern economies has value. I covered a lot of ground in the previous two blog entries.

In the first, which you can read here, I explained why politicians and some economists were wrong to throw up barriers to raising the deficit and the national debt in times when the economy is operating well below capacity, particularly in the years immediately following the Great Recession of 2007-2009.

In the second, which you can read here, I focused on the fact that taxation is what gives value to money that is not backed by something tangible like silver and gold (fiat currency).

The National Debt is Essential

To pause for a conclusion here, I want to emphasize that the national debt is actually essential to a modern economy. Every dollar that you have in your possession is a dollar that the US government has spent into existence and has not yet taxed. But that means it is federal debt, by definition.

So, all the savings that you and everybody else has, denominated in dollars, adds up to the national debt. Talk of eliminating the national debt is not only misguided, it is entirely foolish, because if we did that, all the savings you and everybody else had (denominated in dollars) would simply vanish! Those dollars in your wallet – checking account, or wherever – whoosh, gone instantly. There would be no modern monetary economy at all.

Okay, So Why Borrow to Finance the Deficit?

So if government spending exceeds the amount taken in by way of taxation, why does the government have to finance the cumulative difference (the debt) by selling bonds? Wouldn’t it be less stressful if we did not owe all that money to China or pension funds or to banks or to anyone? Why not just spend the money into existence without borrowing it?

Well probably the most obvious answer to these questions is that many of the ways that government officials and even economists think about money is a holdover from the gold standard era. Back then, governments were truly limited in what they could spend based on how much gold they had in reserve, because people could literally exchange their currency for government gold. In order to prevent people from doing this to the point that it ran out of gold reserves, a government would “soak up” extra currency by selling bonds to finance its debt. This would take currency out of the system for the time being with a promise to pay in the future, when presumably, there would be more gold on hand or the value of the currency would change.

But this is not necessary now because no one has the right to obtain government gold for their currency, since the gold standard is long gone everywhere.

But there is another, more practical reason the government finances its debt by selling bonds – and that is to create a market for them for the express purpose of manipulating interest rates.

Fractional Reserve Banking

When you deposit your money in the bank, that bank does not put your money in a safe and wait for you to come and retrieve it. The bank loans it out. But banks cannot lend out all the money they have on deposit, or they would be broke. They are required to maintain a fraction (about 10%) on hand. This number is called the reserve requirement ratio. Let’s say that at the end of a certain day, a bank is short on its reserve requirement. What should it do?

The first thing it does is consult other banks, because some of them may be over their reserve requirement. In this case the bank that is below would obtain an “overnight loan” from the bank that is above. The interest rate the bank pays on the loan is the overnight loan rate, also known as the “federal funds rate.” Its value fluctuates daily and you can easily obtain its current value by an Internet search. Many interest rates that you pay, including mortgage rates for a home or for a loan on a car, are related to the federal funds rate. So it is a very important item!

Where Bonds Come In

In the presence of a federal bond market, the US government, or its monetary representative the Federal Reserve, can influence the value of the federal funds rate by selling bonds (which takes money out of the system, raising rates) or by purchasing them (which puts money into the system, lowering rates). Normally, these practices are called “open market operations.”

Remember all the quantitative easing policies: QE1, QE2 and QE3? These were unprecedented levels of open market operations of Federal Reserve purchasing of bonds (and other assets before QE3 ended). These policies were undertaken to keep interest rates very low in order to stimulate the economy (making it easier for people to borrow to finance business loans, mortgages, auto loans).

Without the bond market, the federal government would not have that kind of control over interest rates. Some economists have argued that this would be a good thing. Some argue that the result would be a federal funds rate of zero permanently. Some claim that this in turn might very well lead to runaway inflation. But then again, many critics argued that the increasing government debt and quantitative easing would lead to hyperinflation – and that did not happen. However, we will probably never know because it does not seem realistic at the present moment to believe that the government of the US or any other entity that issues its own currency will ever give up the practice of issuing bonds to finance its debts. And, as I think I have shown in this series, there are bigger fish to fry than debating whether or not to abandon bonds.

In my last blog post, which you can read here, I explained the difference between the federal budget deficit and the national debt and showed how they are related to each other. I severely criticized the Republican party for the way its leaders used the issue of the national debt to try to humiliate President Obama throughout his presidency. The Republicans claimed that a $14 trillion dollar debt and then a $16 trillion dollar debt etc. were grave threats to the national economy. I showed that the national debt at these levels was in fact not a threat at all, and that the Republicans and some rogue economists either knew or should have known that this was the case.

Update: Now that the Republicans control both houses of Congress and the White House, they recently passed “tax reform” that will cause the debt to soar to well above $21 trillion. This of course proves that Republican political leaders have simply been opportunists and hypocrites all along, confirming the charges I was making in the previous blog piece. For the purposes of my point, the timing could not have been more ideal.

I ended the previous blog piece by asking the questions: If the national debt is not the problem that “deficit hawks” claim it is, then why should the federal government levy taxes at all? Why not just borrow the money?

How the Modern Monetary System Works

Before I give you the answers to these questions, let me remind you that modern economies use as money what is called fiat currency. This means that the currency is not backed by any physical commodity like gold or silver, it is only backed by government fiat – Latin for “let it be done.” The American dollar, the Chinese yuan, the euro, the yen, the British pound, the Russian ruble are all fiat currencies.

Now we are ready to answer the questions about taxes and debt. The answer to these questions is that taxation is what gives a currency its value. If you ever thought much about it, you probably have considered the horrors of living in a barter economy – where you have to find somebody who has what you want and also happens to want what you have and then strike a deal. So money, of course, ends this problem. But money (read: currency) such as the US dollar must have a foundation in taxation in order to have intrinsic value so that people will accept it in lieu of a good or a service (barter).

The best explanation I have ever heard for this reality comes from Warren Mosler. He was giving a seminar at the time and the story runs something like this. Suppose someone is in a room giving a seminar and holds up his business card and asks who wants one. Many in attendance will take a pass and turn down the offer. After all, you can probably get the presenter’s contact information from the Internet, so the card has little to no value. Now suppose the presenter says, “There is an armed man outside the door who is going to escort you to jail if you attempt to leave the room without handing him one of my cards.” Suddenly everybody wants a card! They simply must have it. Now the presenter says that you must do something like tidy up the room a bit in order to acquire a card. People went from being indifferent about having a card, to wanting one, to even being willing to work to obtain one. That’s quite a turnaround. And it happened because they were coerced by the threat of losing their freedom if they did not hand over the card upon leaving the room.

This is precisely why fiat money has value. As Benjamin Franklin once said, “Nothing is certain except death and taxes.” One way or another, you are going to have to pay your taxes, and since the issuer of a currency (in this case the United States government) only accepts payment for taxes in dollars, you must obtain dollars, just as the folks in the seminar must obtain the business cards. And since everybody ultimately needs dollars to pay their taxes, there is simply no substitute for them. You can talk about gold, silver or even bitcoin all you want, but in the final analysis, you must obtain money in the form of the currency with which you pay your taxes.

Pushing the analogy a little further, imagine what might happen if there are 50 people in the room but the presenter only brought 40 cards. Everyone may be willing to work, but there are simply not enough cards to go around. So some people are just not going to make it out of the room. These people are stuck. In economic terms they are unemployed. No matter how genuine their intentions, they are in dire straits – not because of anything they did wrong, but because of something the presenter did wrong – not bringing enough cards. In other words, the root cause of unemployment is that the government has not produced enough currency. It needs to issue and spend more in order to make it possible for everyone to get out of the room (read: to be employed).

Suppose the presenter brought 60 cards. Some people might be willing to do some extra work to obtain extra cards and they may “employ” someone in the room to do a task for them to in order to obtain a card that they have earned. So now cards are circulating among attendees, just as money circulates between consumers and businesses in the economy. Some attendees may work to gain extra cards so that they will have them when they come to a future seminar. This is the equivalent of economic growth, and is of course desirable. But at some point, if the presenter has brought and hands out an overabundance of cards, attendees who want others to do tasks for them are going to have to offer more cards per chore. The value of the cards will eventually decline in this circumstance. This is inflation, and it comes about when the government issues too much currency for the amount of economic activity people need or desire.

So there you have it. Money has value, not because it is shiny or aesthetically pleasing. It has value because government taxation gives it the traction it needs to have value. And you and I reap the benefits of a stable currency within a stable economy. The challenge is to manage the supply of currency in order to prevent unemployment and inflation. Artificial restrictions on the federal government’s ability to manage the money supply (like a gold standard, fixed exchange rates, a debt ceiling or a balanced budget amendment) are counterproductive and must be avoided. It took decades of the recurrence of devastating depressions, culminating in the catastrophe of the Great Depression of the 1930s before countries such as the USA learned that using a currency backed by metals such as gold was a recipe for continued needless hardship – hence the move toward fiat currencies.

Two Kinds of Entities in the World: (1) The One Who Issues a Currency and (2) Everybody Else

With its own fiat currency, concern about the federal government “running out of money” because of debt is unfounded because the federal government alone creates currency and therefore can never run out. Note that this is NOT true however for state and local governments because they cannot create currency like the federal government can. If they get into debt, it can mean very serious trouble. That is why many states and municipalities have balanced budget requirements.

The same thing is true for a country that does not issue its own currency, like those in the eurozone, such as Greece, which has been facing a national debt crisis for nearly a decade now. Read my blog on a comparison between the debts of a country with its own currency like the USA and one that does not have its own currency like Greece here.

So when the economy of a country that issues its own currency slows down, goes into recession, and unemployment rises, the government has a duty to respond by producing and spending more currency. This will cause the deficit and the debt to rise. Sayings such as, “businesses and families are tightening their belts, so the federal government must tighten its belt too” are erroneous because as we have seen, the entities are not comparable. If the government fails to increase spending in such circumstances, more people will become unemployed and the recession will get worse, just as more people will be stuck in the room if the presenter failed to bring enough cards.

On the other hand, tax cuts when the economy is strong, as it is now, make no sense at all and will increase the debt for no reason other than to transfer wealth from the middle and working classes to the wealthiest, which has really been the Republican economic agenda all along.

A Government That Issues its Own Currency Does Not Need Tax Revenue to Fund its Operations, But it Does Need to Levy Taxes

Another point of the business card analogy is that the federal government does not tax anyone because it needs the money. When you think about it, it would be absurd to imagine that the US government needs dollars from anyone, since it literally can create all the dollars it wants out of thin air. In fact, every dollar you have in your possession or ever have had was literally created by the federal government and then spent. Otherwise you simply would not have it. On the other hand, when the federal government obtains the currency back, it just destroys it – literally, and then creates new currency in its place. It doesn’t need your money any more than the person presenting the seminar needs the business cards collected by the man at the door.

Moreover, notice that taxes do not come first – federal government spending comes first. If the presenter in the seminar analogy does not bring cards and spend them into circulation, then there would be no cards available for the man at the door to collect from the attendees. Similarly, if the government does not spend first, there would be no dollars in circulation among businesses and consumers to collect in taxes. Think about that the next time you hear a person complain about “tax and spend.” They have it backwards – it is spend and tax – and without that, we simply could not have a modern economy at all.

I encourage you to watch the video where Warren Mosler gives the analogy to business cards and money in a debate he had with a “libertarian” economist. Including what I have discussed in the blog, Warren describes the differences between private and sovereign government debt, the benefits of a currency not backed by gold or other metals, and why US government spending, which is often vilified by right wing politicians and the media, is imperative to maintaining a sound economy.

Warren Mosler and Tom Blaine, 2015, Saint Croix

I had the opportunity to meet Warren personally in 2015 near his home in Saint Croix. Here is a photo of the two of us talking economics on an 80 degree January day. Not only is Warren a formidable thinker, he is a gracious host.

So of the two questions I posed near the beginning of the blog, we definitely have an answer to the first: why the federal government must levy taxes. But now a question may have entered your mind that flips the second question (about borrowing) on its head: Why does the US government have to borrow money at all? In other words, if the government can issue dollars out of thin air, why does it borrow money in the form of dollars (from, say China) to finance the debt? We know it really does not need to levy taxes to obtain dollars, so why does it need to borrow to obtain them?

The US undertakes borrowing primarily by selling bonds to banks, pension funds, other governments, etc. with a promise to repay the money with interest by a certain date. As we have seen, the value of the outstanding US federal debt is now approaching $21 trillion. But if we go back to our analogy from Warren Mosler, that would be like the seminar presenter offering bonds to anyone who would lend him his own business cards with the promise that he would pay them back with interest in the future. Why would he do that? It doesn’t seem to make sense, does it? Well it may not make sense, but it is the way the system works, and I will explain why in my next blog.

When someone decides whether to read something or not, including a blog post, they look at the title and determine whether it seems of interest. National income accounting (taxes, spending, the deficit, etc.) is not the most glamorous title in the world BUT maybe the part about money grabbed your attention. Conventional wisdom is that money is the root of all evil, but Mark Twain said it best when he wrote, “Money is not the root of all evil; the LACK OF MONEY is the root of all evil.” And besides, people perk up when the subject turns to money.

Humor aside for a moment, the topic of the deficit and the debt is extremely important. Remember back in 2011 and 2013 when the Congress of the United States seriously threatened to refuse to raise the debt ceiling? Remember the “fiscal cliff” of late 2012? These events caused shock waves to drive through the entire world and almost led to a catastrophe that would have severely damaged the world economy and cost hundreds of millions of people their jobs. And I am not talking about people in the financial sector. I am talking about people in all lines of work – people in communities throughout the United States. You want to talk about community development? Extension does a great job in this effort, but national recessions always rob communities of resources they need in order to thrive, despite the best efforts of elected officials, business people, or outreach educators. That is one of the reasons why I, as a faculty member in Extension Community Development, often teach and write about the national economy and government policies that can damage it or help it.

The difference between the budget deficit and the national debt

Each year the US government collects taxes from the public and spends money on everything from national defense to education. When the government spends more money than it takes in by way of taxes, it runs an annual deficit. If tax revenues exceed spending, we have a budget surplus. Budget deficits are the norm in the USA. Over the past 50 years, we only have had five years of surpluses, one under President Johnson and four from 1998-2001 under President Clinton. As deficits accumulate from one year to the next, the total amount the government owes is called the national debt. The government finances its debt by selling treasury bonds. We hear a lot of hype about who owns these bonds and what happens if they quit buying them. But the truth is that most treasury bonds are held in one form or another by the American public. Pension funds for example, put an enormous amount of the contributions they collect from workers into these bonds because they are such a safe investment. Commercial banks do the same.

Since the US almost always runs an annual deficit, it is obvious that the national debt increases over time. To many people, when they see these numbers, they become alarmed. The national debt first reached $1 trillion about the time Ronald Reagan took office in 1981. President Reagan created all kinds of useless descriptions about the magnitude of this debt – for example stating how high a stack of 1 trillion dollars would be if you piled them all up. This is not a very constructive way to describe any kind of economic phenomenon, but it does often succeed in scaring or angering voters.

The 2011 Debt Ceiling Crisis

As I explained before, the US government acquires a debt by running annual deficits over time. Those deficits are the result of the policies in taxing and spending (called fiscal policies) passed by the Congress and signed by the President. But the Congress also passes laws that limit the amount of national debt the US can acquire. This limit is called the “debt ceiling.” A debt ceiling may seem strange to you, and it really does not make economic sense, but that is what they do. It does not make sense because the debt the US acquires is just a result of the fiscal policy the Congress itself has set. It would be like a family acquiring debt by financing a house, car, etc., based on a household budget it has developed, but then setting some arbitrary debt number that it cannot exceed. Over the years however, raising the ceiling had just been a formality. After all, the Congress had raised the ceiling an average of about 5 times each under President Reagan, Bush 41, Clinton, and Bush 43. But that would all change under President Obama.

In 2010 the Congress set the debt ceiling at about $14.4 trillion. It soon became clear that the US would hit the ceiling by August 2, 2011. Once the ceiling would be reached, the US government would face the likelihood of default on its debt, and would have to take drastic measures, like refusing to pay bond holders, shutting down entire programs, refraining from paying government obligations like money to defense contractors, laying off government workers, etc. More importantly, it would almost certainly cause a US recession and a worldwide economic crisis like we had in 2008.

The Republican leadership of the Congress informed President Obama that they would only raise the debt ceiling under certain circumstances. Many insisted that the President agree to a dollar for dollar cut in government spending (one dollar cut for each dollar increase in the ceiling). Realizing the urgency of the situation, the President agreed to large budget cuts, but only those that would take place in the distant future. As a result, an agreement was reached and the ceiling was raised to $16.4 trillion, which would put off any further crisis until after the 2012 election. Essentially, the parties agreed to “kick the can down the road.”

Junk Economic Science Meets Junk Politics

One question you might be asking is why would the Republican leaders of Congress risk pushing the economy to the brink of a crisis like this? Well that is a great question. Some people really do become alarmed when they see very large numbers, say in the trillions, especially when they are tied to debt. Unfortunately, very few people and as we shall see, including economists, understand the role that national debt plays in an economy of a country that issues its own currency (see my previous blog “Could America Become like Greece?”).

It turns out that a year before the 2011 ceiling crisis, a pair of very well-known economists (Carmen Reinhart and Kenneth Rogoff – hereafter R&R) published an article in the American Economic Review that purported to show that countries with high debt levels experience low rates of economic growth.

Now, if this notion were true, it would provide quite a bit of rationale for “deficit hawks” and others who wish to maintain a debt ceiling or impose a balanced budget requirement on the US government. But some enterprising and skeptical economists soon got hold of the data that R&R used. Thomas Herndon, Michael Ash and Robert Pollin – (hereafter HAP) showed that R&R had omitted a great deal of the data and had coding errors in other parts. These are egregious mistakes, and when HAP corrected them, they showed that the conclusions R&R had made were completely false. R&R acknowledged some of the mistakes fairly quickly, but they denied others, and have since doubled down on the basic claim that high national debt is associated with low growth, even though scholars like HAP have shown that this is simply not the case. Unfortunately, the erroneous view provided by R&R continues to provide cover for politicians who want to maintain the national debt as an issue over which to fight.

The 2013 Debt Ceiling Crisis

At the end of 2012, just after the re-election of President Obama, the US was about to reach the new debt ceiling of $16.4 trillion it had set in 2011, along with a related threat called the “fiscal cliff.” The Congress and the President agreed on a set of continuing resolutions that kept the government funded until October 1, 2013. On this date, the government began a partial shutdown by laying off slightly more than three quarters of a million workers. The Treasury Department warned that even with the layoffs, the government would default by October 17th. On October 16th, the Congress passed a resolution that suspended the debt ceiling. All federal employees went back to work and received full payment for the time they had been laid off. The crisis was over. Seeing the public opinion numbers, Senator Mitch McConnell (R-Ky) vowed that the Congress would not force a ceiling crisis or a government shutdown again. A dreary and completely unnecessary saga in the history of American political economy had finally ended.

Aftermath and Outlook

And the national debt? Well it has risen from $16.7 trillion in October 2013 to $19.8 trillion in July 2017, and is currently rising at $602 billion per year. So, why don’t we hear much about it anymore? I mean, if the debt was a problem at $14 trillion in 2011, and worth a partial government shutdown at $16 trillion in 2013, surely it is a tremendous threat at nearly $20 trillion now – right? It stands to reason, doesn’t it? No, the truth is, it doesn’t, because the national debt was never a problem to begin with. And the alarmists who said it was, whether they were economists who were incompetent or worse, or whether they were politicians who had an axe to grind with a President they wanted to humiliate, dragged the country through years of uncertainty and alarm over nothing.

So you might be wondering – if the government can just run up debt to pay for what it wants, why have taxes? Just borrow the money, right? The answers to those questions lie in the final part of the title to this blog – the part about the value of money. Taxes are used in part to pay for government expenses – that is true. But taxes are what provide the foundation for the value of money. That’s right, the reason that those paper bills and coins you carry around, or those digits on your computer screen when you check your bank account balance or make an online purchase have value at all is because of taxes, as we will see in detail in my next blog.

Since the financial crisis of 2008, the national debts of many nations throughout the world have skyrocketed. Even though the crisis started in the private sector, the balance sheets of national governments quickly turned negative because of reduced tax revenues and a tendency for governments to “bail out” troubled private sector institutions (mainly banks) that were deemed “too big to fail.” Of all the countries in the world, the one that has received the most scrutiny for a rapid increase in its national debt has been Greece. Most Americans are at least somewhat aware that Greece itself has been “bailed out” by the European Union several times since 2010 because it faced insolvency – a situation where it literally could not service its debt or even pay its operating expenses. These bailouts have come with a lot of tight strings attached that have caused the unemployment rate to rise to 27% and nearly half of all Greek households to fall into poverty. Other countries that have had serious national debt/solvency issues include Ireland, Spain and Portugal.

In the United States, both the Bush and the Obama administrations took actions to fight the crisis in 2008 and 2009. These actions resulted in large increases in America’s national debt also. In early 2008, the Bush administration succeeded in getting tax rebates to households and then a few months later agreed with Congress on the Troubled Asset Relief Program (TARP). Together, these initiatives added nearly $1 trillion to the national debt. Soon after he took office, President Obama signed the stimulus package (American Recovery and Reinvestment Act) that was nearly $800 billion added to the debt on top of that.

These actions, which were necessary to prevent the American economy from falling from recession into depression, came under criticism from certain elements in the American political economy. Moreover, annual budget deficits since 2010 have pushed the national debt up to $18 trillion. The critics argued that the influx of all these moneys into the economy would cause hyperinflation and that the resulting national debt would create an insolvency problem in the United States like the one in Greece.

These critics have been wrong on both accounts. First, the inflation rate since 2008 has been the lowest for any seven year period in the post-World War II era. Obviously, the critics who warned of inflation could not possibly have been more wrong about the results. Second, the comparisons with Greece about debt and insolvency are completely inappropriate because Greece is a member of a monetary union and does not issue its own currency. Greece’s debt is denominated in a currency over which it has no control (the Euro). US debt on the other hand is denominated in a currency that only it can issue (the dollar). The difference between these two positions cannot be overstated. What is ironic is that many of the critics who have been sounding the alarm about the US national debt also prescribe “solutions” which would tie the hands of federal policy makers, and lead to a situation where the US indeed could face the problems Greece does. These two “solutions” are: a balanced budget amendment to the Constitution and a return to the gold standard.

Related to the balanced budget amendment is the “debt ceiling.” Another constraint on what the federal government can do to help when the economy slows down, the debt ceiling was once seen as a relatively harmless rule. But in recent years, the Congress of the United States has come very close to allowing this ad hoc rule to push the American economy to the edge of a default crisis. In other words, the United States nearly defaulted on its debt, not because it could not service it, but because the Congress for a time threatened to refuse to service it. Every dollar the US government owes has been a result of spending and tax laws that the Congress itself has approved. The results of the spending and tax laws have led to an increase in the national debt. Simply choosing a number and arguing that we cannot surpass that even when the legislation for taxation and spending rates has been approved serves no useful economic function. This is because the US government can easily create the money to service the debt it owes. The same holds true for why there is no need for a balanced budget amendment at the federal level. Note that this is not the same for the states, because states do not issue their own currency. Like Greece, they must somehow get their money from taxpayers (or get bailed out by the central government) to make ends meet.

The gold standard is another inappropriate suggestion that we currently hear about today. Essentially, the gold standard robs the federal government of its ability to create money when needed to face a potential crisis. To that extent, it is essentially the equivalent of joining a monetary union like the Eurozone. The Bush tax rebates, the TARP, the stimulus program – none of these could have been adopted without the monetary authority in the US (the Federal Reserve) having the flexibility to finance them by printing money “out of thin air.” And it is because of this flexible monetary policy that the current recovery from the “Great Recession” of 2007-2009 is now in its seventh year. Saying that the United States government might run out of dollars to pay its debt is a bit like saying the scorekeeper at a basketball game might run out of points to award the teams if they keep making more baskets.

And the $18 trillion national debt? There is no need to “pay it off.” The government services the debt by paying bond holders interest. Bond holders can sell their bonds to investors, roll them over, or even sell them back to the government, which can always issue the money to pay for them. Won’t that cause inflation? Not when the economy is operating well below capacity – see paragraph 4 above. So no, the US government cannot face insolvency – unless it chooses to place upon itself counter-productive constraints that serve no useful economic purpose, or like Greece, joins a monetary union that essentially has the same effect.

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